(Reuters) — Wall Street traders may be manipulating a key
derivatives market and front running Fannie Mae and Freddie Mac,
hurting the US-owned mortgage giants in the process, according to an
FBI intelligence bulletin reviewed by Reuters.

Using what Federal Bureau of Investigation agents described as
"unsophisticated tradecraft," such as hand signals and special
telephone ring tones, some traders are conspiring to rig rates on
large orders submitted by Fannie Mae <FMNA.OB> and Freddie Mac <FMCC.OB>,
or front running them in the interest rate swaps market, the
document says.

The FBI said in the bulletin that the information came from a former
high-level employee at a U.S. bank and an employee at a Canadian
Bank, plus interviews with other bank workers conducted in 2012 and
2013. The former high-level employee at the U.S. bank estimated the
front running had resulted in profits of $50 million to $100 million
for the bank, the FBI said.

The bulletin did not name any of the traders or banks suspected of
the activity, or indicate whether it may extend beyond the two
banks.

Front running occurs when someone with advance knowledge of another
market participant's plan to make a sizable transaction puts an
order in first, often profiting from a market move that can occur
once the big trade has gone through.

The FBI bulletin is the latest indication that officials are
concerned that traders are manipulating financial markets. U.S. and
European authorities have fined 10 banks around $6 billion for
allegedly manipulating the London Interbank Offered Rate, or LIBOR,
and other interest rate benchmarks, and authorities are actively
investigating comparable behavior in the foreign exchange market.

PHONES PROGRAMMED

Current and former employees at the U.S. bank said that swap traders
at the bank programmed their phones with different ring tones to
identify when certain customers were calling, alerting traders that
a large order was about to be placed, the FBI said.

According to the bulletin, one employee at the U.S. bank and the
Canadian bank employee reported that senior bankers at the two banks
"planned and encouraged this behavior because it led to higher
revenue for their respective parent banks."

Disclosure of the suspected manipulation and front running came in
an FBI intelligence bulletin that was distributed last week by the
bureau's field office in Charlotte, North Carolina, to security
officers at financial services firms.

The FBI said it had "medium confidence" in the information, which
the bulletin described as coming from "multiple corroborating
sources with first-hand access." However, it said it had "low
confidence" that law enforcement could prosecute suspected traders
because the trades concerned seem to be completely legitimate.

"It is standard policy for the FBI to share intelligence information
with our private sector partners to help protect our economy, thwart
crime, and prevent threats impacting American businesses," Shelley
Lynch, spokeswoman for the FBI in Charlotte, said in a statement.
She would not elaborate.

Spokesmen for Fannie Mae and Freddie Mac did not immediately return
calls for comment. Spokesmen for the U.S. Securities and Exchange
Commission and the Commodities and Futures Trading Commission
declined to comment.

Fannie Mae and Freddie Mac, which are government-sponsored
enterprises (GSEs), often submit large swap orders to hedge their
huge holdings of home mortgages against swings in the bond market.
The size of the orders provide an incentive for front running ahead
of the trades.

The interest rate swap market is huge with a notional value of about
$400 trillion. In addition to GSEs, pension funds and insurers use
interest rate swap as a hedging tool, while municipal governments
sometimes enter into these contracts to limit their interest rate
risk on the debt they issued.

The FBI said its sources reported that voice brokers and senior
traders at both the U.S. and Canadian banks encouraged traders to
listen in on calls with the investors to gain transaction
information "which could be used to facilitate front running or
market manipulation."

They would then use hand signals to inform other traders of the
details of the planned swaps, allowing these traders to also
benefit, employees at the banks said, according to the bulletin.